Wednesday, December 10, 2014

Institutional Money Asset Growth Remains Weak and It Matters

Lawrence Goodman, head of the Center for Financial Stability, reminds us that institutional (or 'shadow banking' ) money growth remains weak. A large portion of these money assets disappeared during the crisis so this weak growth means there is still a sizable shortfall relative to its pre-crisis trend. Institutional money assets are an important part of the global financial system and there is a limit to how much of the shortfall can be offset by the growth in U.S. treasuries. So this is a big deal. 

One way to see its importance is to note that these assets function as an important input to economic activity--they reduce transaction and search costs via their medium of exchange role--and therefore their ongoing shortfall reflects a reduction in the productive capacity of the economy. In short, potential GDP may be less because of the shortage of institutional money assets.

Here is Goodman:
The tainted image of shadow banking along with the nefarious sounding name is a disservice to the U.S. economy. Shadow banking to a substantial degree is simply “market finance.” In fact, many cite access to “market finance” as essential to provide the U.S. financial system with strength and flexibility. This market or non-bank based finance provides a stark contrast with the more rigid and heavily bank dominated system in Europe. 
Over the last four decades, market finance has largely provided fuel for corporations in the form of commercial paper and money market funds as well as liquidity for financial markets (see Figure 1). Yet,it also played a central role in enabling many financial crises. In fact, the proliferation of market finance reached unforeseen highs prior to the recent crisis and facilitated numerous excesses. However, CFS data reveal that the reduction in the role of market finance in the economy is likely 
excessively steep and detrimental to future growth. The shadow banking system is under severe strain. Of course, market finance grew too large in advance of the recent financial crisis and the reduction in the sector provides a healthier base for the US economy and markets. Yet, the deterioration is unprecedented. Liquidity provided to corporations and financial market participants via market finance is down a stunning 45% in real terms since its peak in March 2008! In fact, the availability of market finance shows no sign of stabilization with a series of successive drops from the beginning of the crisis to the latest CFS monetary data available through October 2014. 
The shriveling nonbank financial sector threatens the health of the U.S. economy through the curtailment of funds available to corporations and liquidity for financial markets. Typically, the shadow banking system contracts coincident with recessions, but by an average of only 9% in contrast with the 45% witnessed through October 2014. Likewise, the decline from peak-to-trough in market finance is typically much faster at a scant 13 months later. 
The cyclical low in October 2014 marks the 79th month of crises in nonbank finance!
Now the U.S. economy does seem to be turning around despite this problem. Just look at last Friday's employment report. The question, then, is would the economy be doing even better if this shortfall of institutional money asset were not a problem?


  1. Why did you use a linear trend? It looks to me like with an exponential trend, the 2007 levels wouldn't have been that far out of trend.

    1. Kevin, the figure is actually not mine, but comes from the Goodman research note. Yes, an exponential trend probably makes more sense here. I do think, though, that the 2003-2007 spike would still be noticeably different than a non-linear trend. Alas, I don't have the data to check.

  2. That graph would look really different if the 2003-06 spike did not influence the regression. The 03-06 spike was an artificial increase in the supply of AAA assets. Looking at the trend before securitization really took form, the current level of market finance is not too far off.

    There are also many questions not answered in the PDF. Let's say "money" only takes the form of either bank deposits, cash or overnight shadow banking "deposits" (commercial paper and money market). Money should be held generally for its "moneyness" and not as a store of value. In other words, money is whatever assets on balance sheets need to produce cash on demand if needed, to whether possible short-term fluctuations. All other assets are longer-term to earn interest.

    I suppose that's the definition of M3, but then the relationship between M3, NGDP and interest rates is quite complex. Interest rates in 03-06, for example, were likely higher in the , 80's, 90's and 00's due to the unsafe investments earning credibility with savers (junk bonds, dot-com and subprime respectively). Lower interest rates with only positive-NPV investments, either directly or through bank deposits, could have accomplished the same NGDP goal without the capital misallocation. The spike in shadow banking assets was not necessary.